BAML: Oil declines could fuel lower mortgage interest rates in 2015

An examination of break-even inflation rates suggests sharply lower oil prices are a key driver of the 90 basis points rally in 10-year Treasurys and the 60 basis points drop in mortgage rates in 2014, according to analysts at BofA Merrill Lynch.

Most real estate economists are forecasting mortgage rates will rise in 2015, but the recent steep drop in oil prices could change all that.

“The possibility of further declines in oil prices increases the chances that mortgage rates drop to the 3.25%-3.5% range that we believe is necessary to get housing back to affordable levels for many,” says Chris Flannigan, ABS and MBS strategist at BAML. “We have maintained the view that 4% mortgage rates are too high to allow for sustainable recovery in housing. In our view, a drop to the 3.25%-3.5% mortgage rate range would eliminate the current benign technical conditions prevailing in the agency MBS market, increasing supply from both refinancing and purchase mortgage channels. Such a rate drop would also create significant upside risk to our forecast of roughly $1 trillion of mortgage production in 2015.”

Flannigan says that if sustained low rates were realized, which could be possible if sustained low oil prices are realized, the market could see realized mortgage production, which was pegged at a 2.3% 10yr, exceed the forecast by 30%-50%.

Non-agency MBS and consumer ABS would be clear beneficiaries from a lower mortgage rate, lower oil price scenario, he added.

“We continue to recommend an overweight of lower priced subprime mezz, non-judicial option ARMs and consumer loan ABS. Given this week’s weakness in agency MBS, we maintain our neutral view of the sector for now, but re-emphasize our down-in-coupon, long duration bias,” he said. “We are underweight IOS. CLOs and CMBS should broadly benefit from lower interest rates and lower oil prices, but energy specific exposures could be problematic in some transactions and further spread tiering based on relative energy exposure…”